Important Distinctions Drawn by Dissent and Concurrence to Supreme Court’s Decision that Debtors Cannot Unilaterally Rescind Trademark Licensing Agreements

The United States Supreme Court in an 8-1 decision issued on May 20, 2019, settled a split among the Circuits in holding a debtor’s rejection of a trademark license agreement under Bankruptcy Code Section 365 did not rescind the rights of the trademark licensee under the agreement. In Mission Product Holdings, Inc. v. Tempnology, LLC,¹ the Court adopted what is known as the “rejection-as-breach” approach, which holds that post-contract rejection a trademark licensee still retains its rights under applicable state law. The Supreme Court refused to follow the countervailing approach (detailed in our December 13, 2018, alert) that a debtor’s rejection of a trademark agreement effects a complete rescission of the agreement, thereby leaving the trademark licensee with only a prepetition claim for damages in the debtor’s chapter 11 case.

While the decision represents an important victory for trademark licensees in bankruptcy cases, its implications are relatively narrow in scope, as Justice Sotomayor writes in her concurring opinion. The majority did not hold that every trademark licensee has the unfettered right to continue to use the mark post-rejection. The rights of the licensee as defined under state law still remain subject to further review and analysis. In his dissenting opinion, Justice Gorsuch raised another twist: the impact of a trademark agreement expiring during a debtor-licensor’s bankruptcy case.

Executory Contracts: The Basics

Under Bankruptcy Code Section 365(a), a debtor has the option to assume or reject an executory contract. Assumption of a contract obligates the debtor to assume all of the benefits and burdens of the contract and to cure all defaults. If the debtor subsequently breaches an assumed contract, any damages arising are deemed post-petition claims treated as administrative expense priority claims that must be paid in full in the chapter 11 case. In the event the debtor chooses to reject the agreement, under Bankruptcy Code Section 365(g) the rejection is deemed to be a breach of the agreement that arose the day before the chapter 11 petition was filed. In other words, damages that flow from rejection are treated as prepetition unsecured claims often payable at a discount (bankruptcy dollars).

Licenses, Patents, and Trademarks under the Bankruptcy Code

Soon after the enactment of the Bankruptcy Code in 1978, bankruptcy courts began to grapple with the question of what rights a licensee of intellectual property retains or can assert when the debtor-licensor files chapter 11 and subsequently seeks to reject the licensing agreement under Section 365 of the Code. The Fourth Circuit in Lubrizol held that the debtor’s rejection of a patent license agreement terminated the licensee’s rights to use the patent. The logic to this approach is that the license is simply an agreement to forebear from asserting infringement. Under this view, rejection under Section 365 absolves the licensor from continuing to forbear; thus, the licensee’s rights terminate upon rejection and the owner is free to enforce its exclusive rights.

Congress amended Section 365 of the Bankruptcy Code in 1988 to effectively overrule Lubrizol through adoption of Section 365(n). Under Section 365(n), upon a debtor’s rejection of a licensing agreement, the licensee’s rights are preserved with certain restrictions. However, Congress expressly excluded trademark licenses from this provision.

Following the passage of Section 365(n), certain courts held that the omission of trademarks from this section of the Code meant that trademarks are not afforded protection that was specifically granted to copyright and patent licensees (the “negative inference theory”). But in 2012, the Seventh Circuit in Sunbeam declined to apply this reasoning, holding that a debtor’s rejection of a trademark license agreement does not automatically extinguish the licensee’s right to use the debtor’s trademark.² The Seventh Circuit’s logic was premised upon the idea that a license is a completed transfer and thus, a licensee may continue to enjoy the licensed intellectual property postrejection of its agreement by a debtor. As a result, the Seventh Circuit in Sunbeam held that a rejection converts the debtor’s unfulfilled obligations to a prepetition damages claim, but does not “terminate” or “vaporize” the counterparty’s rights.

Other Important Points: Concurring and Dissenting Opinions

Narrowly Defined Scope

Justice Sotomayor joined the majority, agreeing with the Supreme Court’s baseline decision that the debtor’s rejection of the trademark agreement did not terminate the licensee’s rights under the agreement pursuant to the applicable non-bankruptcy law. Justice Sotomayor summed up the majority’s decision as embracing the notion that a debtor’s rejection of an existing contract under Bankruptcy Code Section 365(n) “functions” as a breach of contract, rather than unwinding the rejected contract as if it never existed. However, Justice Sotomayor astutely observed that, “Trademark licensees’ postrejection rights and remedies are more expansive in some respects than those possessed by licensees of other types of intellectual property.” Justice Sotomayor noted that under Section 365(n) of the Bankruptcy Code, which applies specifically to patents and copyrights, “A covered licensee that chooses to retain its rights postrejection must make all of its royalty payments; the licensee has no right to deduct damages from its payments even if it otherwise could have done so under nonbankruptcy law.” In other words, the categories of intellectual property specifically covered by Section 365(n) of the Bankruptcy Code are governed by different rules than trademark licenses. What remains unanswered is the extent to which a trademark licensee could pursue equitable remedies (such as specific performance) against the licensor under state law.

The Agreement Expired During the Chapter 11 Case

Although the lone dissenter, Justice Gorsuch took issue with the entire decision because after the chapter 11 case had been commenced, the license agreement expired by its own terms, which effectively mooted the issue in his view. The fact that the majority did not address the license agreement’s expiration leaves open the question of what damages the licensee may assert based on the post-petition conduct of the parties. Namely, where a trademark license agreement expires by its own terms during the licensor’s bankruptcy case, the licensee’s remedy would be limited to asserting a claim for damages under the terms of the trademark agreement for the licensor’s failure to perform while the agreement was in effect.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Evan Jones, an O’Melveny partner licensed to practice law in California and the District of Columbia, John Rapisardi, an O’Melveny partner licensed to practice law in New York, Jennifer Taylor, an O’Melveny partner licensed to practice law in California, Suzzanne Uhland, an O’Melveny partner licensed to practice law in California, the District of Columbia, and New York, and Amalia Sax-Bolder, an O’Melveny associate licensed to practice law in New York, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

© 2019 O’Melveny & Myers LLP. All Rights Reserved. Portions of this communication may contain attorney advertising. Prior results do not guarantee a similar outcome. Please direct all inquiries regarding New York’s Rules of Professional Conduct to O’Melveny & Myers LLP, Times Square Tower, 7 Times Square, New York, NY, 10036, T: +1 212 326 2000.